Monday, December 21, 2009

Control Without Ownership

The need for investors to ensure that management incentives are aligned with those of shareholders is a topic that is often discussed, including on this site. But an equally troublesome incentive structure, though rarer, is that which occurs when certain shareholders have control without the corresponding level of ownership that justifies that control. Ben Graham wrote on this topic in Security Analysis, and while such structures are not as common today as they once were, they still exist.

Consider Dover Downs Entertainment (DDE), a gaming company in Delaware. Henry Tippie, the company's chairman, controls the company (i.e. has a majority of the equity votes). However, he actually owns a significantly smaller stake of the company's shares: Class A shares get 10 votes each, while common stock shares get one vote.

Such a divergence between control and ownership misaligns incentives. The controller could seek to enrich himself at the expense of the company, since company payouts do not hurt him as much as they would had he an ownership stake corresponding in size to his controlling stake. Furthermore, the controller could resist a takeover which would benefit financial shareholders, due to the loss of prestige and loss of control that would accompany a merger.

If an investor does encounter a company that one shareholder controls, the ideal scenario for the investor is such that the controlling shareholder also owns a large corresponding stake, does not receive large benefits from the company relative to his share of the company's earnings, and has a significant portion of his personal wealth tied up in the company's equity. Such structures may actually prove advantageous to the minority investor, and examples of such structures can be seen in Fairfax Financial and Berkshire Hathaway. Dover Downs, however, is no such example.

It should be noted, however, that Tippie may be obligated under contract to act in the best interest of the largest shareholder. Furthermore, for all we know he might be an upstanding citizen of the highest integrity; this article does not question his ethics. However, the point is that the incentive structure of the controlling shareholder does leave much to be desired.

That is not to say an investment in Dover Downs Entertainment may not payoff. The P/E is under 10, the company appears to have certain competitive advantages, and the company generates generous amounts of cash flow. However, investors should be aware of the risks that exist when a controlling shareholder does not own a majority stake in the business which he controls.

Disclosure: None


Anonymous said...

If you want some clues to how Tippie treats investors look no further than sister company Dover Motorsports (DVD). His track record isn't pretty.

Mariusz Skonieczny said...

You definitely got that right. Tippie really amazes me. The same principle "control without ownership" applies to Dover Motorsports. I wrote two articles on Dover Motorsports. If you are interested, you can read them on Seeking Alpha.